Archive for August, 2012

People are stupid. No, no…not you. You’re sharp as a tack. I was referring to everyone else. Those other people, well, they’re the reason we have to put the protective language on the side of this website that reads:

The items in this blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation.

If we didn’t, readers would base their critical tax decisions on a blog post rife with toilet humor and Simpsons references, and we can’t have that.

Consider the case of Ralph Holmes. Holmes, by all indications, was one of the “smart” ones; he was a surgeon after all. But even the brightest among us occasionally put the batteries in the remote backwards, and it appears Holmes chose to let his intellectual guard down when preparing his tax return.

In 1997, Holmes founded a C corporation, receiving 1,000,000 shares of stock in MacroPore Corporation for 1 cents per share.  In 2000, Holmes cofounded another C corporation, LeonardoMD, Inc.

During 2000, Holmes decided to start selling his shares of MacroPore so he could acquire more shares of LeonardoMD. Between 2000 and 2004, Holmes sold 972,500 of his 1,000,000 MacroPore shares, generating nearly $3,000,000 in capital gains. The gains, however, were never reported on Holmes tax returns. And why not?

Because one of Holmes’ coworkers told him he had “read an article” concerning a tax provision that permits taxpayer to roll over gain from a startup company into another startup company and defer the tax.

The provision in reference, of course, is Section 1045, which does permit a taxpayer (other than a corporation) to defer recognizing gain from the sale of qualified small business stock that is reinvested within 60 days into additional qualified small business stock. The problem is, Holmes never bothered to read Section 1045. In fact, there’s no evidence that Holmes even bothered to read the article his coworker referenced. Instead, he just heard “your gain can be deferred,” and ran with it, neglecting to report the gains on his 2000-2004 returns.

Had he actually read Section 1045, Holmes would have realized that there are a number of statutory hurdles that must be met before a taxpayer can defer gain on the sale of stock under this provision, including:

  • The sold stock must be held more than six months;
  • Both the stock sold and the stock purchased within 60 days must be a “qualified small business stock.” This is further defined as a C corporation that has aggregate gross assets of less than $50 million before and after the issuance;
  • The stock must be acquired at its “original issuance;” in other words, the individual must put the cash into the corporation in exchange for stock. The stock cannot be purchased from an existing shareholder.
  • Lastly, and most importantly, Section 1045 deferral must be elected. It must be elected by the due date (including extensions) for filing the income tax return for the year in which the stock is sold. Generally, it’s elected by reporting the gain in full on Schedule D, and then removing the gain on Schedule D by showing the amount deferred as a capital loss.

Because Holmes failed to timely elect to defer the gain — and in fact, never reported the gain at all — the Tax Court refused to allow any deferral. Furthermore, the court noted that Holmes could not prove that the two corporations qualified as “qualified small businesses,” as he failed to provide evidence that both corporations had assets less than $50,000,000, and it appeared that some of the stock in LeonardoMD was purchased from an existing shareholder rather than acquired at original issuance.

The lesson? Read the statute. Better yet, hire a tax professional to read the statute for you.

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Kevin Larievy and his ex-wife separated in 2004. Hoping to keep it amicable, they chose not to get attorneys involved and crafted their own separation agreement. Pursuant to their purely oral compromise, Larievy agreed to pay his ex-wife $2,605 per month for living expenses and support of their child. Apparently, the two parties had an understanding as to how much of the payment constituted alimony and how much constituted child support, but the allocation was never memorialized in writing.

Larievy made the required payments through 2008, when the divorce was finalized. As part of the final divorce documents, Larievy was to pay $1,400 of monthly alimony to his ex-wife commencing on December 1, 2008 and continuing until death of either party.

On his 2008 tax return, Larievy deducted $19,200 of the payments made to his former spouse as alimony. The IRS allowed a deduction for the $1,400 that was paid pursuant to the finalized divorce agreement dated December 1, 2008, but none of the payments that preceded December 1st.

The Tax Court sided with the IRS, citing I.R.C. § 71, which provides that in order for a payment to be deductible as alimony, it must meet four conditions:

1. The payments must be received by (or on behalf of) a spouse under a divorce or separation agreement;

2. The instrument must not designate the payment as a payment which is not includible in the payee’s gross income;

3. The payor and payee must not be members of the same household; and

4. The payment obligation must end upon the death of the payee.

Fatal to Larievy’s cause, however, was I.R.C. § 71(b)(2), which defines a “divorce or separation agreement” as a written agreement. According to prior case law, I.R.C. § 71 requires a written agreement because Congress was interested in requiring a clear statement of the separation agreement so it could be determined with certainty the amount of payments to be included in the wife’s income and the allowable corresponding deduction available to the husband. [i]

Because Larievy’s agreement with his ex-wife was not in writing — despite the fact that the two had mutually agreed on the amount of each payment that represented alimony — Larievy was not entitled to any deduction prior to those made pursuant to the final divorce decree in December 2008.

[i] Garner v. Commisssioner, T.C. Memo 1973-79

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Expanding on our post from earlier today, assume that as part of an M&A transaction, a buyer agrees to pay $10,000,000 to an investment banker upon the successful closing of the deal.This type of lump-sum fee paid upon consummation is quite common, and is typically referred to as a “success-based fee.”

Prior to 2011, the regulations at Treas. Reg. §1.263(a)-5 provided the general rule that a success-based fee facilitated a transaction, and thus was generally nondeductible. A taxpayer was permitted, however, to rebut this presumption by maintaining sufficient documentation to establish that portions of the fee were 1. not inherently facilitative to the transaction, and 2. incurred prior to the “bright-line test date,” in which case they would be currently deductible.

Anyone that has ever completed a transaction cost study knows that this was an onerous requirement, forcing the taxpayer (and the tax advisor) to sort through what could be several years worth of documents to prove that a portion of the success-based fee was being paid for services that met both tests required for current deduction.   

In Revenue Procedure 2011-29, the IRS greatly liberalized the treatment of success-based fees by providing a safe harbor, whereby a taxpayer could treat 70% of a success based fee as an amount that did not facilitate the transaction and deduct it currently while only being forced to capitalize the remaining 30%. Using the number above, $7,000,000 of the success-based fee would be deducted, and $3,000,000 capitalized.

But what if prior to paying the success-based fee, the taxpayer is required to make non-refundable milestone payments to the investment banker?  What if instead of paying the $10,000,000 only upon the closing of the deal, the taxpayer was required to fork over a $1,000,000 payment upon the signing of the LOI and an additional $1,000,000 upon shareholder approval of the transaction, with the payments being credited to the $10,000,000 due upon completion of the deal? Would those $2,000,000 in payments qualify for the safe harbor 70/30 election?

According to an IRS Ruling issued last week, the answer is no. In CCA 201234027, the IRS concluded that because the milestone payments were not refundable, they were not “success-based fees.” Seems logical to me. And because they were not “success-based fees,” they were not eligible for the RP 2011-29 safe harbor. As a result, in order to deduct any of the $2,000,000 in payments, the taxpayer was required to establish, based on all the facts and circumstances, that the investment banker’s activities were 1. not inherently facilitative and 2. incurred before the bright-line test date.

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When finalized in 2003, the Section 263(a) regulations governing the treatment of transaction costs changed the way we treat expenses incurred by both an acquiring and target company pursuant to an acquisition. Under these regulations — specifically, Treas. Reg. §1.263(a)-2T(c)(3) — the general rule is that no deduction is allowed for an amount paid to acquire or create an intangible, which under Treas. Reg. §1.263(a)-4(c)(1)(i), includes an ownership interest in a corporation or other entity.

Stated in a more simple manner, if you own a business that is either acquiring another business or being acquired, any expenses incurred by the business as part of investigating, pursuing or closing the transaction are generally not deductible.[i]

The regulations provide an exception to this general rule, however. If certain transaction costs are incurred prior to a “bright-line test date,” provided those costs are not “inherently facilitative” to the transaction[ii], the business can deduct the costs currently.

The key, then, is what constitutes the “bright-line test date.”  The regulations at Treas. Reg. §1.263(a)-5 define this date as the earlier of:

1. the date on which a letter of intent, exclusivity agreement, or similar written communication is executed by representatives of the acquirer and target, or

2. the date on which the material terms of the transaction are authorized by the taxpayer’s board of directors.

So, in summary, all costs before the earlier of those two dates may be deducted, provided they are not inherently facilitative. Once you hit that point of no return, however, all costs incurred in pursuit of the transaction must be capitalized.

Last Friday, in CCA 201234026 the IRS addressed the impact a “go shop” provision has on this bright-line test date. In the Ruling, an acquirer and target had set the terms of an agreement in a merger agreement that was executed by representatives of both corporations and approved by both corporations boards. In other words, the bright-line test date had been reached.

The agreement, however, also contained a “go shop” provision that provided that after the date of the merger agreement, Target was permitted to seek better offers from potential acquirers. If Target found a better deal, Target could cancel the merger agreement and choose the better option, or the acquirer could match the terms of the better deal.

The taxpayers argued that the “go shop” provision extended the bright-line test date until the time that the provision expired and the deal was consummated. The IRS disagreed.

The “go shop” provision is only one of the terms of the merger agreement and does not serve to negate the document’s execution, nor does it trump the approval of those terms by the corporations’ boards of directors. Therefore, the bright-line date is the date of the merger agreement’s execution and its approval by the corporations’ board of directors.  

[i] See also Treas. Reg. §1.263(a)-5(a).

[ii] Amounts are inherently facilitative if they are paid to: (1) secure an appraisal, formal written evaluation, or fairness opinion; (2) structure the transaction (including the negotiation of the structure and the obtaining of tax advice on the structure); (3) prepare and review the documents that effectuate the transaction; (4) obtain regulatory approval for the transaction; (5) obtain shareholder approval for the transaction; or (6) convey property between the parties. General due diligence costs are not considered inherently facilitative but, rather, are to be analyzed under the bright-line date rule.

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Do you love flowcharts?

Or endless citations?

How about reading through various actions involving P and S?

/says the last part fast and giggles like a school girl

If that sounds like you, then you may enjoy this article I recently had published in the September issue of Taxes Magazine, titled “Identifying Reverse Acquisitions and the Resulting Tax Consequences”.

The reverse acquisition rules of Treas. Reg. 1.1502-75(d)(3) are among the most complicated rules within THE most complicated area of tax law: the consolidated return regulations. Unfortunately, many tax advisors don’t realize a reverse acquisition has occurred until it’s too late, and as a result, the wrong tax returns are filed for the wrong periods, creating a mess that can take significant time and effort to unwind.

In this article, I establish five tests tax advisors can employ to determine whether a reverse acquisition has occurred, and then go on to discuss the resulting tax consequences of a reverse acquisition. I hope you enjoy; it’s got all the P and S you can handle.

/can’t stop giggling

Click here for a PDF of the article:  Identifying Reverse Acquisitions and the Resulting Tax Consequences

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One of the most revealing aspects of using WordPress as a blog host is having the ability to track the different search engine terms that have ultimately led people to Double Taxation.

Through analyzing this data, I’ve realized two things:

1. There are some sick, sick people out there. To wit: the single-most common string of words that have led web users to this blog during its 18-month history is “power ranger porn.”  Sadly, I’m not making that up. Needless to say, when these deviants wound up getting this blog post instead of whatever depravity they were hoping for, they were more than a little let down.

2. People really want to know whether they can claim a tax deduction for mortgage interest they pay on a mortgage that’s not in their name. My previous discussion on the issue has been an oft-searched post, a result I attribute to our depressed economy. With banks having tightened their purse strings, many non-traditional arrangements for home ownership have sprung up. In many cases, the individual who owns the home and borrows the mortgage is not the same individual who lives in the home and pays the mortgage.

These arrangements are not unique to primary residences. Consider the case of Omar Abarca, a real estate investor who owned rental property through six partnerships. Because Abraca had limited borrowing capacity, each time he wished to purchase a rental property he would enter into a partnership; Abraca would contribute cash, while the other partner would use their borrowing ability to take out a mortgage and purchase the desired property. Abraca would then pay all the operating expenses of the property, including the mortgage interest.

It was unclear whether the borrowing partner ever actually contributed the title of the property to the partnership. What was clear, however, was that Abraca was never listed on the title for each property, nor was he listed as a lender. On his tax returns, Abraca failed to acknowledge the separate legal existence of the partnerships, opting instead to report the activity for each rental property directly on Schedule E, where he deducted the mortgage interest paid on behalf of each property.

The IRS challenged the deductions, asserting that because Abraca was neither the title holder nor the borrower on each property, he was not entitled to deduct the mortgage interest.

To support their position, the IRS cited I.R.C. § 163, which begins by providing the general rule that “There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.”  However, I.R.C. § 163 further provides that the indebtedness must be an obligation of the taxpayer, and not an obligation of another. An exception to the general rule that interest paid on an obligation of the taxpayer is deductible only by that taxpayer is found in Treas. Reg. §1.163-1(b), which provides in part that:

“Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness.”

In summary, just as with primary residences, in order for an individual to deduct interest expense on a rental property he must be either:

1. named as a borrower on the mortgage, or

2. be either the legal owner or equitable owner of the property.

Because Abraca failed to establish that he met either test, the Tax Court sided with the IRS, holding that Abraca was not entitled to deduct any of the mortgage interest he paid on behalf of the rental properties.

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In nearly every Masters in Taxation program across the country, first-semester students are required to take a “Research and Writing class,” in which a humbling process repeats itself over and over: First, the student is assigned a topic and asked to research it thoroughly before handing in a written memo summarizing their findings. At which the professor ritualistically destroys the student’s hard work by going to town with a red pen,with nary a sentence left unscathed.

This, of course, is done by design. The professors intend to show you that the tax world is no-nonsense, and that while you may fancy yourself a skilled writer because your buddies enjoyed the hilarious narrative you included with your Evite to a Halloween pub crawl, you don’t know the first damn thing about technical tax writing. And of course, they’re right.

Eight years later, two lessons from Research and Writing stick with me to this day:

1. It’s where I learned that when writing a tax memo, you have to include everything necessary to support the conclusion, but just as importantly, nothing that doesn’t. The reader doesn’t need to take in a single sentence that’s not germane to the ultimate finding. And second,

2.”Dealer versus investor” issues are a tax advisor’s nightmare. This was the assigned topic for my final paper, and after suffering weekly literary de-pantsings at the hands of my professor until I finally got it right, I came to realize that because of the uncertainty surrounding whether income generated from the sale of certain assets generates ordinary income or capital gain, it often places the tax advisor in a precarious position.

Let’s review: the determination of whether a taxpayer holds a piece of property as inventory or a capital asset is based on all the facts and circumstances. As the courts tend to do in situations like this, they established a test commonly referred to as the “Winthrop Factors.”

The Winthrop Factors are most often applied in the context of a taxpayer who purchases multiple pieces of property — whether it be undivided raw land, subdivided land, or spec homes — and begins selling them off. The taxpayer, as you might imagine, wants the properties to be treated as investment assets that are capital in nature, with the resulting gain subject to the preferential rates afforded capital gains.  

The IRS, on the other hand, routinely argues that the assets are “held for sale in the ordinary course of business,” and thus are excluded from the definition of capital assets by virtue of I.R.C. § 1221(a)(1). As a result, any gain would be characterized as ordinary income.

To determine on which side of the fence particular assets fall, the Winthrop Factors examine the following nine..uh…factors:

(1) the taxpayer’s purpose in acquiring the property;

(2) the purpose for which the property was subsequently held;

(3) the taxpayer’s everyday business and the relationship of the income from the property to the taxpayer’s total income;

(4) the frequency, continuity, and substantiality of sales of property;

(5) the extent of developing and improving the property to increase the sales revenue;

(6) the extent to which the taxpayer used advertising, promotion, or other activities to increase sales;

(7) the use of a business office for sale of property;

(8) the character and degree of supervision or control the taxpayer exercised over any representative selling the property; and

(9) the time and effort the taxpayer habitually devoted to sales of property.

Earlier today, the Tax Court got to put the Winthrop Factors to the test in Flood v. Commissioner, T.C. Memo 2012-243. In Flood, the taxpayer was a day trader (read: unemployed) who started buying up vacant lots. Flood would examine public records to determine which property owner to contact in order to purchase the lot, mail the property owner a letter, prepare agreements and deeds, and pay legal fees to clear title and ensure closing.

Once he owned the lots, Flood performed no subdivision of the lots, nor did he construct homes on them. Instead, he simply advertised the lots on a website and in print, before engaging a real-estate agent to help him sell the lots.

From 2001 to 2008, the Floods purchased at least 250 lots. Flood sold two lots in 2004 before selling 40 lots in 2005. On his 2004 and 2005 tax returns, Flood reported a combined capital gain in excess of $1,000,000 from his sale of the lots.

[Ed note: Full disclosure: when I initially read these facts, I presumed that a careful review of the Winthrop factors would reveal that the vacant lots were capital assets, largely by virtue of the complete lack of development activity undertaken by Flood in improving the lots. As is often the case, I was wrong.]

The IRS argued that Flood held the lots as inventory and the gain should be taxed as ordinary income. The Tax Court agreed.

Citing the first factor, the court determined that Flood’s primary purpose for acquiring the lots was to make money by buying the lots at a bargain and reselling them. As evidence, the court noted that although Flood only sold some of the lots he had previously purchased during 2004 and 2005, the gains generated from those sales was “spectacular.” In addition, Flood only sold off his high-value lots, continuing to hold his lots that hadn’t appreciated to the same degree. While I would call this practice “Investment 101,” the Tax Court saw it as evidence that the primary purpose was not to hold the land for investment, but to make a quick profit.

Further incriminating Flood was the fact that his day trading activity wasn’t particularly profitable. Because the income generated from the sale of the real estate was exponentially greater than his stock-trading activity, the court concluded that the sale of the lots was his primary money-making endeavor, not an investment.

In addition, the court concluded that the most important factor — the frequency, continuity, and substantiality of the sales of the lots — weighed against Flood. The two lots sold in 2004 had been purchased in 2003. Of the 40 lots sold in 2005, 11 were purchased in 2001, 15 in 2002, and 12 in 2003. These short holding periods were not indicative of an investment intent.

Lastly, while Flood did not develop the property (factor 5) or use an office (factor 7), the court found that he did devote considerable efforts to the sale of the lots (factor 9) by contacting home owners, drafting agreements, advertising, and using a broker. Again, while I would consider those actions to be the minimum required for a real estate investor, the Tax Court saw it differently.

Ultimately, the court held that the Winthrop Factors weighed against Flood, and the income generated from his sale of the vacant lots was ordinary, rather than capital in nature.

The lesson? Even after 100 years of case law, dealer versus investor issues are still largely a crapshoot. Here, Flood did no subdivision, undertook no improvements, and appeared to perform only the minimum activities necessary to buy and sell the properties, yet the court concluded that the lots were inventory, rather than capital assets. There’s not much more to add, other than if you’re planning to subdivide and sell raw land, be warned.

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